Oil and water? Basel III and best practice in trade finance

Feature |3 May 2012

RUTH WANDHÖFER highlights the challenges that Basel III brings in the area of trade finance from the financier’s perspective and is hopeful of best practice winning the day

Without a doubt, the financial industry is facing a number of challenges. One huge one is the advent of Basel III measures. Designed to improve the overall stability of the financial system, a raft of new requirements have been introduced – including more and better quality capital, liquidity requirements and an overall leverage ratio.

A closer look at area of trade in particular suggests that regulators have been less thoughtful about the potential impacts of some of their well-intentioned proposed measures. Recent experiences in the context of the euro crisis, shortage of US dollar liquidity and early signs of Basel III implementation are all contributing to a potential re-shaping of this part of the financial landscape.

This article looks at recent developments in the area of trade finance, the overall Basel III requirements and their potential impact on trade finance, and concludes by suggesting next steps with a view to ensuring a balanced regulatory response that limits unintended consequences to the area of trade finance and the impact on economic growth.

Recent developments in the trade finance landscape

Over the past 18 months, bank cost of debt has risen, especially among European banks. Credit default swaps (CDS) for European banks have spiked, indicating a perception of increased credit risk. The impact of credit rating agencies downgrades of a number of players has further impacted the cost of raising capital and Basel III is looming on a horizon which turns out to be nearer than some of us might have thought, with banks already looking to raise more capital in preparation. Furthermore, recent months have seen the effect that the European sovereign debt crisis has had – and is continuing to have – on European banks, in particular those that have large exposures to GIIPS countries (Greece, Italy, Ireland, Portugal and Spain).

The cumulative effect of all this has resulted in US dollar liquidity being scarce for European banks, which has directly impacted on their ability to participate in trade as well as financial transactions in general and foreign exchange (FX) – all areas that are dominated by US dollars (see Figure 1).

While this dollar dearth has been mitigated by recent European Central Bank (ECB) interventions (which increased euro liquidity and then facilitated access to US dollars) banks are still reviewing their trade portfolios more carefully, a move which is expected to lead to some assets being offloaded onto the market.

A key contributor to this rather bleak environment now being experienced by European banks has been the way the European Union ran bank stress testing compared to the US. While the US focused on the amount and composition of capital, testing the banks’ Tier 1 risk-based capital ratios and specifically looking at the proportion of Tier 1 common equity as the most important protection in comparison to more senior parts of the capital structure, the EU considered Tier 1 capital without any specific focus on the proportion of common equity.

At the level of bank asset valuation the US included all assets while the EU looked at assets with the exception of those that could be sensitive to a sovereign debt shock. As a consequence the potential risk of a sovereign shock – only assessed for banks’ shorter-term trading book in Europe – remained largely understated.

Another key difference was that the US required failed banks to immediately recapitalise; whereas the EU, which identified a number of failed banks in their first round of the stress tests, did not insist on immediate recapitalisation.

The move from Basel I to Basel III

As a brief reminder, the global set of prudential recommendations, known otherwise as the Basel framework, was first established in 1988 with a view to establishing a minimum total capital ratio to be held by banks to ensure protection against credit risk. The credit risk model primarily focused on solvency risk. At the time the regime applied risk-weights per counterparty category. In 1996 the standardised or value at risk (VAR) model for market risk was added to the framework.

From then on Basel II began to evolve and was finalised in 2005. This time, while retaining the minimum capital requirement, the proposals also enhanced the overall sensitivity of credit risk measurement, expanded the scope of risks to also include operational risk, but remained rather focused on solvency risk.

As a reaction to the financial crisis the Basel Committee for Banking Supervision (BCBS) adopted the next version – known as Basel III – in 2010 (further information is available here). This time, the regime demands a significant increase of both the quality and the quantity of capital. Two additional elements are being introduced with the liquidity regime and a common leverage ratio. In addition, systemically important banks will have additional capital requirements. The regime, expected to start being phased in from 2013 with deadlines for the different elements extending up until 2019, will need to be legally implemented by all countries. That in itself will be a significant challenge, given the unimpressive track record of many countries in implementing Basel II or even Basel I.

Basel III in more detail

Experience with the earlier Basel regimes showed that the quality, consistency and comparability of regulatory capital are key ingredients to a more stable financial market. In the past different forms of capital, including hybrid capital, were permissible, but now Basel III defines that the predominant form of regulatory capital must be common shares and retained earnings – the so-called Tier 1 common equity. In the area of deductions and other prudential filters it has also been recognised that local variations can lead to very fragmented results and hence more risk. Therefore these will be harmonised internationally and banks will be required to disclose all components of their capital base.

Two additional capital buffers are also being introduced, with the capital conservation buffer (required regardless of the state of the economy, which may result in constraints on capital distribution) and the countercyclical capital buffer. The latter can be triggered by national regulators to dampen credit expansion during periods of excess growth and release accumulated surplus to absorb losses in terms of contraction.

To supplement the revised capital framework, Basel III also introduces a leverage ratio of 3%. One point to note here is that unlike the Federal Reserve’s current US leverage ratio, which is based on GAAP (generally accepted accounting principles) assets, the new international leverage ratio will also incorporate most off-balance sheet items at 100% conversion factor. This will have a particular impact on trade related activities.

A completely new approach is taken with the liquidity regime. Basel III establishes global standards for high quality liquidity buffers, introducing the liquidity coverage ratio (LCR) for short-tem liquidity under severe stress scenarios and the net stable funding ratio (NSFR) on the longer-term sustainable maturity structure of assets and liabilities.

The G20 agreements also focused on addressing the ‘too big to fail’ dilemma. As a result, higher capital and liquidity buffers will be required from the indentified ‘global systemically important banks’, or G-SIBS.

In the same vein, internationally operating players would need a more harmonised regime for resolution, which is tackled in the emerging ‘recovery and resolution’ frameworks that the US and UK have been front-running so far.

Another area that is significantly impacted by these measures is the Export Credit Agency (ECA) business. With an historic credit conversion factor (CCF) of 0%, given the government guaranteed nature of these transactions, the jump to a 100% CCF of ECA assets for inclusion in total assets that are subject to the non-risk based leverage ratio is staggering. In addition, the short-term liquidity regime does not consider these assets as eligible liquid assets, even though sovereign guaranteed and historically displaying very low loss given default rates – this represents an additional cost as other liquid assets will need to be put in place for the liquidity buffer. When then looking at the NSFR, and in light of the long tenor that ECA transactions usually have, matching long-term capital will be required, rather than wholesale funding. Again, a significant new cost that will have to be absorbed.

Trade finance under Basel III: the challenges to come

A key impact to global trade is expected from the newly introduced leverage ratio. Designed to constrain leverage and supplement the risk-based measures, the leverage ratio also includes assets that are currently off-balance sheet, for example:

commitments including liquidity commitments;

direct credit substitutes;

acceptances;

standby letters of credit;

trade letters of credit;

failed transactions; and

unsettled securities.

A 100% credit conversion factor (CCF) has to be applied to all of these; which represents a significant increase. Only for unconditionally cancellable transactions the CCP (central counterparty) has been set at 10% (from the previous 0%).

Ever since the emergence of these proposals, the industry has been vocal on highlighting that this proposed universal CCF for all off-balance sheet exposures is not in line with the actual limited risk of highly documented, short term and self-liquidating trade instruments. Trade transactions are held off-balance sheet until processing is verified (more than 50% fail their original submission) and because many expire unutilised (86% of guarantees and standbys per ICC study).

Paradoxically, trade transactions not only represent real underlying economic activity but are requested by customers not by banks to create leverage.

Basel III and trade: like oil and water?

The challenge the industry is facing highlights the fundamental inconsistency. The new capital, leverage and liquidity requirements are already creating a disincentive for some banks to advise and confirm letters of credit or provide financing via export credit agencies (ECAs). Coupled with that, the decreased liquidity available for trade finance, the conditions for trade finance and therefore the ability to provide support for growth of the global economy are increasingly challenging.

The most vulnerable stakeholders such as small medium enterprises (SMEs) and subsidiaries of multinationals operating in emerging markets are already starting to feel the impact. Such an outcome is very much at odds with the G20’s goals of readily available low-cost trade-related funding to boost global growth.

A final element to consider is the potential fragmentation of Basel III implementation. If a number of economically important countries and regions were to refrain from implementing Basel III or if they implement Basel III differently, this could trigger capital arbitrage across the banking spectrum – an outcome that is hugely undesirable.

Next steps

In terms of next steps, industry efforts, for example under the umbrella of BAFT-IFSA, are continuing to highlight to regulators the challenges and potential unintended consequences for those parts of society that are most reliant on trade finance. In collaboration with the International Chamber of Commerce (ICC) a significant data gathering exercise has been undertaken over the last year or so to develop a comprehensive register on trade finance, clearly demonstrating the very low risk and short-term nature of this type of financial transaction (further information is available here).

Given the absence of fundamental revisions so far at the level of the Basel III framework it is at least clear that nothing will legally apply to banks until governments implement their local enabling legislation. Against this background the European Commission has been first in proposing a comprehensive revision of the existing Capital Requirements Directive (CRD) in order to implement Basel III.

The text is still in negotiation and the positive news is that specific concessions for trade finance – in particular in relation to short-term trade transactions – are slowly emerging within the amendments proposed by the European Parliament so far.

However, long- term credit agency backed financing would also need to be considered for specific treatment to ensure that the real economy does not unnecessarily suffer as a consequence. Europe has the chance to endorse a best practice approach on Basel III when it comes to trade finance.

Ruth Wandhöfer is head of regulatory and market strategy, GTS at Citi ruth.wandhofer@citi.com